International Tax Primer - University at Buffalo · International Tax Primer Andrew D. Oppenheimer, ... International tax concepts US persons: ... Importance of a foreign corporation’s

International Tax PrimerAndrew D. Oppenheimer, Esq.October 31, 2017

Agenda

International tax concepts

Taxation of foreign earnings

Sourcing of income and expenses

Foreign tax credits

Subpart F income

Transfer pricing

Recent developments

Reform proposals



Worldwide – An approach to taxation used by countries like the US, that taxes its citizens, resident aliens and domestic corporations on their worldwide income

This approach creates risk of double taxation on the same item of income (i.e., by country of residence and by country of source)

In the US, this double taxation can be mitigated in the following ways:

Foreign tax credit (“FTC”) with respect to certain foreign taxes, which is elective

Deduction for foreign taxes paid

Tax treaties

Nonresidents and foreign corporations are generally subject to tax by a country using worldwide taxation only on income from sources in that country

Territorial – An alternative approach that taxes only income earned in that country


US persons: US taxes worldwide income of US persons To prevent double taxation of foreign source income, may annually elect to

claim a credit for foreign income taxes If no election, foreign taxes are deducted

Credit is limited to portion of taxpayer’s pre-credit US tax attributable to foreign source income

Non-US persons: US uses a two-pronged system to tax US source income of foreign persons

US source investment-type income is subject to gross basis withholding tax (30% subject to reduction by treaty)

Net amount of income effectively connected with a US trade or business is subject to tax at the regular graduated rates

Taxation of US and non-US persons


Deferral Foreign subsidiary is not includible in US consolidated return US generally does NOT tax a foreign subsidiary’s undistributed foreign

source income Result Defer residual US tax until sub pays a dividend Policy Help US companies compete outside the US

Anti-deferral Deny deferral to “tainted” foreign earnings Simultaneously allow deferral for active foreign business profits Specific regimes

Subpart F (enacted in 1962) PFIC (enacted in 1986)

Taxation of US-owned foreign corporations


Passive Foreign Investment Company (“PFIC”) - §1297(a)

A foreign corporation is categorized as a PFIC if either:

75% or more of its gross income is from passive income, or

50% or more of the value of its assets either produce or are held for the production of passive income.

Adverse tax treatment

Generally, US shareholders of PFICs are subject to tax and interest charges on any “excess distributions” from a PFIC, including any gain on the disposition of PFIC stock (unless an election is made to include the income annually).

An investor could be exposed to potentially severe tax liabilities by not identifying the PFIC status of the foreign equities held in a portfolio.

What is a PFIC and why do we care?


Controlled Foreign Corporations (“CFCs”) - §957(a)

Any foreign corporation if more than 50% of –

1) the total combined voting power of all classes of stock of such corporation entitled to vote, OR

2) the total value of the stock of such corporation, is owned (within the meaning of §958(a)), or is considered as owned by applying the rules of ownership of §958(b), by US shareholders on any day during the taxable year

US Shareholder

A US person who owns , or is considered as owning by applying the constructive ownership rules of §958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation

This US person could be subject to deemed income inclusions under Subpart F with respect to a CFC (Subpart F is an exception to deferral)

What is a CFC and why do we care?


Earnings and profits (“E&P”) A measure of the income/dividend capacity of a foreign corporation

Based upon domestic concepts

It could be a deficit

Book earnings of the foreign corporation plus/minus adjustments

Tracked separately for each foreign corporation

Maintained in the foreign corporation’s functional currency

Tax pools A measure of the potentially creditable foreign taxes paid by the

foreign corporation attributable to its E&P

E&P and tax pools: Important tax attributes used in FTC planning


USP

Foreign Holdco

Foreign Holdco

Foreign Holdco

USS

Foreign Holdco

Foreign Holdco

Foreign Opco

Foreign Opco

Foreign Opco

Foreign Opco


CFCs Subpart F income is limited to current E&P, and reduced by a qualified deficit in E&P Section 956 inclusion is limited to applicable earnings Gain on sale of CFC stock is dividend to extent of E&P Annual reporting of current and accumulated E&P

PFIC E&P is used to determine annual inclusion (if elected)

Foreign corporations in general E&P is used to determine if a distribution is a dividend E&P is used to compute deemed paid FTCs E&P is used in applying look-through rules for basketing dividends Deemed dividend from inbound subsidiary liquidation or inbound reorganization is based

on all E&P amount

Interest expense apportionment Basis in stock of CFC is increased by E&P

Importance of a foreign corporation’s E&P to US shareholders

International tax concepts: Sourcing


Income sourcing and expense allocation are important for purposes of determining a taxpayer’s ability to use FTCs

Note: does not change total taxable income of US person

Sourcing rules determine taxable income of foreign persons

Why is sourcing important?

Total taxable

income

US

sourceincome

Foreign

sourceincome


Goal: determine geographic origin of income

Gross income

Step 1: determine statutory category (interest, rents, dividends, etc.)

Step 2: apply category-specific source rule

Deductions

Step 1: allocate to related class of gross income

Step 2: apportion between US and foreign source income based on factual relationship of deductions to gross income

Overview of sourcing process


Interest – sourced to residence/place of incorporation of payor

Dividends – sourced to place of incorporation of payor

Rents/Royalties – sourced to location of property/permitted place of use

Personal Services – generally place of performance

Sale of Real Property – sourced to location of property

Sale of Personal Property – generally sourced to location of property

Inventory – sourced to place of sale where title passes to buyer, generally. Also consider special rules (section 863(b) sales – 50/50)

General income sourcing rules


Regulations under §861

Interest expense (special rules due to fungibility)

R&D expenditures

State income taxes

Net operating losses

Stewardship expenses

Losses from sale of property

Legal and accounting expenses

Charitable contributions

Expense apportionment rules

International tax concepts: Foreign tax credit regime

Foreign tax credit regime

General rules

Foreign taxes are deductible business expenditures

Foreign tax credit regime is elective

FTC is generally preferable to a deduction

FTC reduces US income tax liability dollar-for-dollar

A deduction, however, may be preferable in an NOL context

Consider the FTC limitation (§904)

It limits the FTC to the US tax on foreign source taxable income

How might you maximize the FTC? Maximize foreign source income and minimize foreign source deductions

Remember that not all E&P and related tax pools are the same

Credit vs. deduction of certain foreign taxes


Direct credit Available under §901 (and §903) A credit for taxes imposed on and paid by the US taxpayer (e.g.,

withholding tax or foreign taxes paid by the US for operations in a foreign branch)

Indirect (deemed paid) credit Available under §902

To US corporate shareholders who directly own 10% of voting stock For taxes imposed on a foreign subsidiaries within the “Qualified

Group”

Available under §960 To US corporate shareholders that have an income inclusion under §951(a)(1) (i.e., subpart F income or a §956 inclusion from a CFC)

Types of FTC


Section 901 – Taxes paid on income of foreign branch or partnership

Section 903 – Taxes withheld by foreign payers of dividends, interest or royalties

Sections 902 and 960 –Taxes of foreign subs that

are deemed paid upon receipt of dividend

USP

Foreign payers

► Dividend► Interest► Royalties

USP

Foreign subsidiary

► Dividends► Subpart

F inclusions

USP

Foreign branch

Income

Types of FTC (cont.)


If US corporation earns income from foreign operations through a branch, US corporation is treated as paying the foreign tax directly and may, subject to the FTC limitation rules, receive a direct FTC (i.e., a §901 credit)

US Corporation includes $1,000 in its income and claims a FTC of $250

Example of section 901 direct FTC

Foreign Net Income (before reduction for taxes) $1,000Foreign Tax Paid $250

Foreign branch

US corporation


Example: USCo operates a foreign branch that has $100 of foreign earnings. Foreign tax rate is 20%, US rate is 35%

Section 901 example: Credit vs. other methods compared

Methods of mitigating

double taxation

Foreign

tax+

US

tax=

Effective

tax rate

None $20 $35 55%

Deduction for foreign tax $20 $28 48%

Credit for foreign tax $20 $15 35%

Exemption for foreign

income$20 $0 20%


Also known as the “deemed paid” credit

The US corporation is deemed to have paid, for purposes of §901, certain foreign taxes paid by foreign corporations if it satisfies the 10% direct ownership threshold

Available when foreign subsidiary makes actual or deemed cash and non-cash dividends (i.e., distributions treated as dividends under §301(c)(1))

Available when there is an income inclusion under either the subpart F rules or as a §956 inclusion from a CFC

Section 902/960 indirect (deemed paid) FTC – 1st tier subsidiaries


Qualification requirements

Minimum 10% direct ownership at each level

Minimum 5% indirect ownership through chain

Dividend distributions up to US parent

Number of qualifying tiers

Can look down to the 6th tier (but only if CFCs)

What if the taxes reside below the 6th tier?

Tracing foreign taxes to dividends

Section 902/960 indirect (deemed paid) FTC - Lower tier subsidiaries

Dividend

US corporation

CFC

CFC

Dividend


If US corporation receives a distribution from CFC who earned the income and paid foreign tax, US corporation has not directly paid any foreign taxes and thus cannot receive a §901 credit

However, under §902, US corporation will treat the $30 of taxes paid by CFC as deemed paid by US corporation and thus creditable

US corporation will include $100 in gross income($70 dividend plus $30 §78 gross-up) and may be able to claim a FTC of $30 against US tax due of $35 ($100 x 35%)

Section 902/960 indirect (deemed paid) FTC - Example

Foreign Income $100Foreign Tax $30Foreign E&P $70

$70Dividend

US corporation

CFC


Purpose Limit credit to US tax on foreign-source income Credit is not intended to offset US tax on US-source income

How to increase limitation? Gross income Maximize foreign-source income for US tax

purposes (e.g., §863(b) sales) Deductions Maximize US-source deductions for US tax

purposes (e.g., §861 allocation)

Foreign tax credit limitation - Section 904

Pre-creditUS tax= x

Foreign-sourcetaxable income

Total taxable income

Foreign taxcredit limitation


General rule – Separate limitations applied to:

Passive category income

General category income

How separate basket limitations work

Allocate total foreign source income and total foreign taxes between two baskets

Compute separate limitation and separate credit for each basket

Total credit = sum of credits from each basket

Separate basket foreign tax credit limitations – Section 904(d)

Total taxable

income

US

sourceincome

Foreign

sourceincome

General

categoryincome

Passive

categoryincome

International tax concepts: Subpart F

Subpart F income

Perceived abuse:

Deferral provides a tax incentive to channel investment income, inventory trading profits, and other portable income through a foreign corporation based in a low-tax foreign jurisdiction

Income earned abroad subject to lower tax rates that could have been earned in the US

Without Subpart F, no US tax on income until repatriated by a CFC due to the general rule of deferral

The “problem” with “portable” income

Subpart F income

Assume:

German CFC manufactures goods for sale by US corporation in the US market.

Cayman CFC has no substance (no employees, no office, etc.)

Example of perceived abuse

CFC(Germany) Sells goods @

10 per unit

CFC(Cayman)

US corporation

Manufactures goods COGS: 10 per unit

Sells goods @ 20 per unit


Subpart F income

To target the perceived abuse, certain categories of income (“tainted income”) became subject to immediate inclusion in the US Shareholder’s taxable income

Tainted income

Subpart F income (foreign base company and insurance income)

Investments in US property

Subpart F inclusion

Immediate inclusion whether or not actual dividend received by US Shareholder of CFC

FTC available

Subsequent distributions treated as previously taxed income (so-called PTI)

Overview

International tax concepts: Transfer pricing

Transfer pricing

Definition:

Pricing of transactions between controlled entities

Perceived abuse:

Due to the special relationship between related parties, the transfer price may be different than the price that would have been agreed between unrelated parties

In general

Transfer pricing

Assume:

German CFC manufactures goods for sale by US corporation in the US market.

Cayman CFC has no substance (no employees, no office, etc.)

Example of perceived abuse

CFC(Germany) Sells goods @

10 per unit

CFC(Cayman)

US corporation

Manufactures goods COGS: 10 per unit



Transfer pricing

Section 482

Gives IRS authority to make allocations necessary to “prevent evasion of taxes or clearly to reflect the income of…organizations, trades or businesses”

It also provides that in respect of intangible property transactions, “the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible”

Goal

Ensure that pricing of transactions between controlled entities is consistent with the pricing of transactions between third parties (the so-called arm’s length standard)

Rules and regulations

Transfer pricing

Objective Encourage taxpayers to make reasonable efforts to determine and document the

arm’s-length character of their inter-company transfer prices

Unless a taxpayer can demonstrate reasonable cause and good faith in determination of the reported transfer price, 20% non-deductible transactional penalty on a tax underpayment attributable to a

transfer price claimed on a tax return that is 200% or more, or 50% or less than the arm’s-length price, or

40% if the reported transfer price is 400% or more, or 25% or less than the arm’s-length price.

Contemporaneous documentation To avoid a transfer pricing penalty, a taxpayer must maintain sufficient documentation

to establish that it reasonably concluded that, given the available data, its selection and application of a pricing method provided the most reliable measure of an arm’s length result and must provide that documentation to the IRS within 30 days of a request for it in connection with an examination of the taxable year to which the documentation relates.

Potential penalties

Recent developments

Recent developments

Temp. Treas. Reg. §1.482-1T(f)(2), T.D. 9738 (aggregate valuation in transfer pricing)

Treas. Reg. §1.6038-4, T.D. 9773 (country-by-country reporting)

Treas. Reg. §§1.987-0 through 1.987-11, T.D. 9794 (gain or loss on functional currency)

Treas. Reg. §§1.367(a)-0, 1.367(a)-1 through -7, 1.367(d)-1, 1.6038(b)-1, T.D. 9803 (final 367 regulations)

Treas. Reg. §§1.721(c)-1T through -7T, 1.6038B-2T, T.D. 9814 (transfer of “built-in gain property” to partnership)

Treas. Reg. §§1.385-1 through -4, T.D. 9790 (final section 385 regulations)

Regulations

Recent developments

Debt push down – Inversion example (double dummy structure)

New foreign parent

Foreign merger sub

Foreign parent

Stock and note

Cash and stock

S/Hs

Cash

Merger

Cash and stock

USmerger sub

US parent

Public

Merger

Cash and stock

Cash and stock

Stock and note

New foreign parent

US parent Foreign parent

Public S/Hs

Creditor Debtor

Recent developments

How should we repatriate FS1’s 100x of earnings?

Repatriation strategies – All cash Ds

USP

FS2 FS1

E&P: 100xTaxes: 30x

E&P: 0xTaxes: 0x

Tax rate: 10%

AB: 100x

FMV: 100x

AB: 10x

FMV: 100x

Recent developments

USP transfers its shares of FS2 to FS1 in exchange for 100x cash/note and immediately after, FS2 files an election to be treated as disregarded from its owner from its owner, FS1.

Repatriation strategies – All cash Ds (cont.)

USP

FS2 FS1

FS2

FS2 stock100x

cash/note1

2

Recent developments

Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner Decision July 13, 2017. Decision – Tax Court rejected the IRS’s longstanding position in Rev. Rul. 91-32 and held that the gain on the

disposition of a US partnership interest by a foreign partner was US-tax-exempt.

State aid (EU): Amazon:

Final decision published in October 2017. Decision –The EC found that Luxembourg approved non-arm’s length royalty payments to be paid to

Luxembourg entities. GDF Suez:

Opening decision published in January 2017. Decision –The preliminary decision by the EC is that Luxembourg misapplied the law.

Apple: Final decision published in December 2016. Decision –The EC found that the rulings given to the Irish subsidiaries endorsed an inappropriate

attribution of profit within the Irish subsidiaries and constituted illegal state aid. €13 billion (plus compound interest).

Sale of Novo Banco with additional aid in the context of the 2014 Resolution of Banco EspíritoSanto S.A.: Decision published in October 2017. Decision –The EC has approved Portuguese aid for the sale of Novo Banco.

Cases

Recent developments

Objective: “aligning transfer pricing outcomes with value creation”

Important: adherence to arm’s length principle explicitly affirmed (didn’t have to be that way –could have taken formulary apportionment road).

Respect for separate legal entities (including decisions to capitalize subsidiaries)

Respect for allocations of risk (subject to “accurate delineation of transaction” analysis):

Risk/return trade-off

Risks do not have to align with functions (e.g., contract R&D)

Need to fully remunerate contributions to value

BEPS guidance is not always clear and is subject to different interpretations; BUT, adherence to ALP provides a key discipline/check on its interpretation.

BEPS Action Plan (2013)

Reform proposals

Reform proposals

The current US worldwide tax system will be replaced “with a 100-percent exemption for dividends from foreign subsidiaries (in which the US parent owns at least a 10-percent stake).”

As part of a transition to this new dividend exemption system, the proposal “treats foreign earnings that have accumulated under the old system as repatriated. Accumulated foreign earnings held in illiquid assets will be subject to a lower rate than foreign earnings held in cash or cash equivalents. Payment of the tax liability will be spread out over several years.”

The proposal states that additional international rules will be provided to stop corporations from “shipping jobs and capital overseas.” “To prevent companies from shifting profits to tax havens,” tax rules will be provided “to protect the US tax base by taxing at a reduced rate and on a global basis the foreign profits of US multinational corporations.” The tax committees also “will incorporate rules to level the playing field between US-headquartered parent companies and foreign-headquartered companies.”

House proposals expected to be released November 1

Questions

International Tax Primer - University at Buffalo · International Tax Primer Andrew D. Oppenheimer, ... International tax concepts US persons: ... Importance of a foreign corporation’s

Documents